With business investments, choose low-hanging fruit first

With earnings season in full swing, many of you are going to be reevaluating current or potential investments. Therefore, let me once again address the issue of selecting potential investment candidates and then determining their potential value.

The question of selecting companies is a bit complex for a newspaper column, however, let's slice the proverbial Gordian knot with regard to the question of valuation and couch the answer in terms of intrinsic value. Intrinsic value is the present value of a specific cash flow that a company could potentially generate into perpetuity.

Another integral part of present value is the discount rate used. How do you determine that rate? It is the rate of return you demand of your investments. Regular readers know that I usually require a 15 percent return. Finally, there is the question of what particular cash flow we are talking about.

The flow of cash could come from a variety of sources. Two of my favorites are earnings and free cash flow to the firm. A third commonly used methodology is the dividend discount model.

The intrinsic value calculation is projecting a specific cash flow, such as earnings per year, for some number of years from which you then determine the present value of that cash flow. For example, the dividend discount model projects dividends going forward at a specific rate of increase and then calculates the present value of that dividend flow.

Numerous web sites, such as Value Pro.net and Quicken.com, require only a stock symbol to supply an intrinsic value. ValuePro.net uses the basis is free cash flow to the firm, while Quicken.com uses a discounted earnings model.

The intrinsic value should be between 30 and 50 percent higher than the stock price. There are nearly 10,000 listed shares. You are looking to build a portfolio of between 15 and 20. Make your life easy and pick the low-hanging fruit.

When I write about a company, I always include the intrinsic value using the two techniques just described. I do so to enable you to duplicate what I did as a part of your own research.

Let's look at an example. General Electric (GE) has disappointed investors over the years. The intrinsic value of the shares using the discounted earnings model is $3.56 using a 5-year average earnings growth rate of 9.72 percent and a discount rate of 15 percent.

Using a discounted free cash flow to the firm model, the intrinsic value is zero. The discount rate being used is the average cost of capital, which in this case is 6.48 percent. GE would not meet my initial criteria to continue an analysis of the company.